Was the Fed’s latest easy-money move yesterday an act of sheer desperation? Was this move triggered by a gridlocked financial sector that’s in imminent danger of imploding when the next shoe drops?
In spite of repeated rate cuts and massive central bank sponsored liquidity injections over the past few months – credit markets remain frozen and refuse to thaw out. A glance at this graph of Libor lending rates tells you that.
Remember, Libor has been an accurate barometer to watch for changes in this credit crunch all along. Lending rates first skyrocketed last summer, indicating growing financial market anxiety, the first round of credit stress. 
The Fed, working with other central banks beat back the liquidity crunch for awhile, but it flared up again last fall. More easy money over the year-end holiday season pushed rates lower once more. As you can see, Libor rates have stubbornly climbed yet again in recent months. The credit crunch just won’t go away.
The problem is this: Banks, brokers, hedge funds, and other institutional investors are locked in a real “Mexican stand-off”, but without the pistols. Instead, the deadly arsenal these financial firms hold are pieces of an estimated $650 billion worth of sub-prime securities still outstanding. To date, the financial sector has “only” fessed-up to about $190 billion in losses... so far.
This tells me there are still a lot of potential losses sitting in financial sector portfolios as yet unaccounted for.
Anatomy of a Credit Crunch Standoff
Nearly everyone has some of these securities of highly questionable value on their books. No one can be sure what any of these securities are really worth... at fair market value... precisely because there is no fair and orderly market at the moment.
It is an acute crisis of confidence that has paralyzed these markets. The financial players at the table are already all-in. All of their equity capital chips on the table, fully at risk. These firms don’t have much confidence in the true value of their own mortgage backed securities holdings – let alone have confidence enough to buy someone else’s potential junk debt – and maybe get left holding the bag.
Everybody knows that somebody else will soon announce another huge write-down. It could be anybody. But one thing everybody is sure of is that somebody BIG (like the Fed) should really step in and bail us all out – so everybody can just get back to business as usual.
Fed Steps in as Buyer of Last Resort
When there is no longer confidence in underlying asset values – there simply isn’t any market, no trading, period. So the financial sector players sit silently at the table, sweating, and waiting for the turn of the next card. Now in steps the Fed, in its role as lender of last resort.
The Fed offers to reshuffle the deck... and with considerable slight-of-hand... deals everyone a new hand.
If financial firms don’t have the confidence to trade these mortgage backed securities with one another, the Fed says: “just trade with the U.S. Treasury. We will swap your AAA-rated securities for freshly minted Treasury bonds... no problem.”
Never mind that there’s very little confidence in the reliability of these so-called AAA credit rating at this point... “These credits look just right to us. So we’ll take ‘em off your hands in exchange for the highest-quality government script... no worries.”
Putting Off the Financial Day of Reckoning Yet Again
The Fed’s timing in this latest easy-money move is curious indeed. In just 15 days or so, banks, brokers and other financial firms will close their books on the first quarter. Then in come the accountants.
According to the latest financial accounting standards governing mark-to-market valuations, firms are forced to mark down the value of securities of questionable value at quarter’s end... like mortgage backed securities.
In other words, with just a few weeks left before another potential round of massive forced write-offs of sub-prime securities, in steps the Fed with an offer to swap these securities for Treasuries for a term of 28-days… conveniently beyond the end-of-quarter valuation period!
So the real question is: just how bad were first-quarter financial sector write-offs shaping up to be, that the Fed made such a drastic move. Was this merely a shameless attempt to paper-over and cover up the true magnitude of more severe mortgage loan losses?
Perhaps, but the Fed has only succeeded in pushing back the ultimate day of financial reckoning – disaster deferred – until sometime down the road. Stay tuned!
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